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Two questions emerge now that community banks will get an extended shot at funds that make up the Troubled Asset Relief Program. How many will actually apply for the capital? And will the money actually be made available to them?

Treasury Secretary Timothy Geithner recently announced that smaller banks, those with total assets below $500 million, will have six more months to apply for injections of capital from the $700 billion rescue fund. He also said these banks can ask for booster shots of up to 5 percent of their risk-weighted assets, instead of the original 3-percent limit.

Geithner said there was roughly $110 billion left in the TARP fund. Geithner also said he expects the larger banks that were bailed out by the fund would return about $25 billion to the account. The dollars that will come back, whatever the final tally will ultimately be, would then be made available to the smaller community banks.

“The question, though, is when the money is returned, whether the initial authorization from Congress permits a redeployment of those funds,” said Phillip Torrence, managing partner in the Kalamazoo office of Honigan, Miller, Schwartz and Cohn LLP.

“What they’re seeking to do is to potentially amend the rules to permit these smaller community banks to take out more,” he said of Treasury officials.

But some members of Congress have argued that the existing TARP rules do not contain a provision that allows the returned billions to be redistributed. They said any returned money should be applied to the federal deficit, instead of being offered to the financial industry again. So Congress may not do what Treasury wants done.

“I don’t think anyone would disagree with the assertion that community banks have been neglected, as part of all this. The banks, particularly here in West Michigan, have really in large part avoided the risky practices of their mega-bank peers that caused a lot of these problems,” said Torrence, who consults community bank officials in 16 states.

“While access to additional capital would be a good thing for many banks, including those here in West Michigan, I think institutions are going to be careful in considering whether or not to take the funds.”

Why? Because of the damaging image the media, investors and taxpayers can attach to a bank that receives public bailout dollars.

“There have been some national stories about banks out of the southeast that have returned the funds. Some recipients of TARP funds have had a negative impact on their stock price. There seems to be an undercurrent in the market that certain investors are cautious of lenders that are operating under this heightened government and, frankly, taxpayer scrutiny that comes with TARP,” said Torrence.

Another reason community banks may not go after TARP capital has to do with the rules that accompany taking the funds, especially those that restrict compensation for top-level executives. A bank that takes TARP money could lose a key senior manager to one that hasn’t, and at a time when bank in need of public dollars is struggling to remain competitive.

“By the way, the rules that go with TARP funds can be changed at any point in time, which is a risk,” said Torrence of the possibility that a rule change could come after a bank accepts those dollars.

As for the stress test the Federal Reserve administered to the nation’s 19 largest banks, Torrence said he didn’t know the results would be made public and felt the grades should have been kept private. The results revealed that 10 of the financial institutions that were tested needed to raise $75 billion in private capital, while nine were given a passing grade. (See related chart.)

“I don’t think it does the marketplace or anyone else any real benefit by publishing them on the front page of the Wall Street Journal. The stress test is a snapshot at a point in time. So how the economy goes is how the banks are either going to improve, or continue to experience further pressure and compression with respect to the loans they have out there,” he said.

“Clearly, capital helps because the banks are more able to withstand additional failure and to shore-up their allowance for loan losses. The best way out of this is really to try and find a way to help turnaround all the borrowers who are defaulting on their loans.”

The mega lenders in need of raising the private capital are limited to selling off portions of the business or issuing new stock. The danger to doing the latter is that current shareholders could be put off from having their holdings diluted.

So Torrence felt some of the banks should sell existing operations or select assets to bulk-up their balance sheets. If those institutions do that, he said community banks might find themselves on a more level playing field.

“The super regionals and the mega banks have gotten to the point that they’re so big now they may be forced to divest themselves,” he said, “which puts our local community banks in a position where they’re in a totally different competitive mode.”

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